Sunday, October 25, 2015

Futures-implied probability of a 2015 rate hike in the United States remains below 40%. Some market participants have all but dismissed this possibility as they look at weak global growth as well as soft inflation and inflation expectations in the US. Some have even suggested that the next policy move by the Fed should be a rate cut into negative territory.

Source: St. Louis Fed

However global growth and US inflation expectations may not necessarily the main focus at the Fed. For example, numerous economists continue viewing the energy market crash as having only a transient impact in inflation. The logic here is that if we freeze crude oil prices at current levels (below $45/bbl), by early 2016 the year-on-year change will be around zero.

And a number of energy analysts expect crude oil prices to begin gradually rising going forward. To many forecasters this would imply that crude oil price weakness will no longer have such a severe impact on the rate of inflation.

Of course some would say that low fuel prices have not yet fully made their way through the economy - suggesting that the disinflationary pressures will persist for some time. Similarly some argue that the full effects of the dollar rally in the first half of 2015 are yet to be fully felt.

Nevertheless many economists view the headline inflation approaching the core measures by early 2016, with the core CPI turning higher as well. Moreover, a slew of recent US economic reports suggests that while the US economy probably slowed in the second half due to dollar strength and weakness abroad, the effect may be transient.

The housing market for example continues to recover and consumer sentiment and spending does not seem to be impacted by the recent market volatility.

Source: St. Louis Fed

Source: Scotiabank

Source: @GallupNews

Source: Deutsche Bank, @MKTWeconomics

Even US manufacturing which has been under pressure recently is showing signs of stabilization. The latest Markit manufacturing PMI report surprised to the upside.

Source: Markit, Investing.com

But what about the relatively poor payrolls report for September, which clearly missed expectations? Some economists argue that this is as much about slower hiring as it is about tight labor markets. For example (as we saw in the latest Pulte Homes quarterly report), the homebuilding industry is struggling with acute labor shortages. Of course as the Wall Street Journal recently pointed out, the US housing correction has been so severe that a whole generation of construction workers has permanently exited the industry, creating shortages as the sector recovers. Nevertheless when the Fed hears about labor shortages in an industry such as housing, they take notice.

Source: WSJ

Signs of tighter labor markets have also appeared in the latest NFIB reports on small business. When speaking with small businesses it becomes clear that there is no shortage of applications for each opening they have. But they can't seem to find people with the right experience and/or skill set (skills gap).

Source: NFIB

Moreover, the broader unemployment measures continue to improve. Here is the so-called "U-6" for example, which according to some economists is about 1% away from "full employment" (see quote).

Source: St. Louis Fed

Whatever the case, many argue that this is a precursor to acceleration in US wage growth. We haven't seen a great deal of evidence of that so far, but many economists (including those at the Fed) are convinced that it's only a matter of time.

One of the concerns the FOMC had in September was the risk of a rapidly deteriorating economy abroad, particularly in China. It has since become clear that while China's economy continues to slow, the combination of aggressive fiscal and monetary stimulus there is likely to cushion the decline.

Source: Investing.com

Some may remember that in September of 2013 in the wake of the so-called "taper tantrum" the Fed decided to continue with QE. The central bank however started tapering three months later. The "playbook" this time around could be similar.

Are global markets prepared for a December liftoff? It seems that while credit markets remain cautious, there is much less uncertainty priced into US equity markets. A relatively strong employment report next week for example could reignite market volatility.

Source: BAML

Many argue that the US economy can withstand a rate hike at this point. Indeed it can. However, given that much of the world is currently in a monetary easing mode, such a move by the Fed would result in a further rally in the US dollar. We saw the Bank of Canada strike a dovish tone recently, the PBoC is in the middle of a major easing cycle, the BoJ is in a perpetual QE, and the ECB is fully expected to expand its stimulus.

A further dollar rally would exacerbate the rout in emerging markets, potentially forcing China to resume the RMB devaluation. Disinflationary pressures in the US could worsen and the manufacturing sector would take another hit. Nevertheless, it seems that many at the Fed are willing to overlook such an outcome and begin the first rate hike cycle in nearly a decade.

Saturday, October 24, 2015

As a petro-currency, the Canadian dollar has fallen from parity with the USD by as much as 30% in the space of less than two years. In 2009, Canada`s current account turned negative, after a long period of supporting economic growth ( Chart 1). We have sustained deficits ever since, exacerbated by the collapse of the oil prices and the failure of the non-energy sectors to pick up the slack in exports. The current account deficit has ranged between 2-3% of GDP, a significant loss in terms of incomes, output and jobs.

As the deficits persist, Canada needs to import capital to finance the trade deficit and to stabilize its currency. The influence of the capital account is often over-looked in determining the fluctuations in a country`s currency, yet its role in the balance of payments can be just as significant as that of trade balances.

The Importance of Capital Inflows

A various times in Canada's history, foreign investment has contributed to :

* an appreciation in the Canadian dollar;

* the lowering of domestic interest rates;

* the bidding up of Canadian assets in natural resources, financial, and in real estate sectors;

* the long term financing of our external public and private debt.

In short, the capital inflows are central to the shaping of the economy. Now that the current account is in deficit, future capital flows are going to play a vital role in the mapping the path of future economic growth.

Canada has and continues to be both a supplier ( assets) and receiver (liabilities) of capital with the rest of the world. However, we continue to be in a net liability position and hence rely upon capital inflows to support our economy. Chart 2 compares flows of capital in and out of the country.

What makes up the Capital Account

There are three basic components of the capital account.

* Portfolio investment. This investment is usually traded in the secondary markets, such as stocks and bonds, It has expanded enormously in recent years with advancements in technology and de-regulations, allowing for more cross-border trade and a much wider choice of financial instruments ( e.g ETFs, derivatives, etc).

* Direct Investment. This form of cross -border investment results in a significant degree of control though equity ownership in the management of a Canadian company by non-residents. The importance of direct investment has diminished as fewer Canadian companies have given up control to foreign entities .

* Other investments. This category includes short-term bank loans and deposits and responds to fluctuations in interest rates and domestic currency.

Recent Developments in Capital Flows

Canada has been the beneficiary of huge inflow of portfolio capital since the 2008 crisis. The boom in commodity prices worldwide encouraged foreign investors to seek out resource development projects in oil, gas , and other minerals. Financing for mergers and acquisitions was plentiful as Canada was viewed as a safe economic and political environment with a well- established infrastructure . Chart 3 illustrates the dominance of portfolio investment , dwarfing other forms of capital inflows.

The influx of capital , however, had an adverse impact on our trade balance. The loonie appreciated by 15% between 2009 and 2012, at one point trading above par against the USD. However, the Canadian economy continued to grow, albeit modestly, as the resource sector expanded and the benefits were felt throughout the economy.

Of special note , the rise in the value of the loonie occurred all the while Canadian mid- to long-term interest rates were below those of the US; normally, this interest rate spread would have discouraged money to flow into Canada. Over this same period, for every $1 dollar of equity investment, foreigners purchased $3 in bonds. The overweight in debt financing is reflective of the worldwide reduction in borrowing costs as corporate bond spreads narrowed in Europe and North America.

Another way to view the capital account inflow is to consider the book value of foreign investment in Canada (Chart 4). Over the period 2009-2013, the book value of direct investment grew at 20% in total; the value of portfolio investments by 51% and other investments by 31%. The preferred instrument for financing the current account was and continues to be through debt instruments.

Nevertheless, capital inflows into Canada are trending down. International investors in energy are more attracted to opportunities in the US where costs are lower. In addition, investors have a wide choice of resource developments in emerging markets. In a word, Canadian assets are losing some of their prior allure, as international competition is stepped up.Concluding Observations

1. Now that the super cycle in commodities has ended with a hard landing, our trade balances will continue to be under pressure and that means the loonie will be down for the long count. Furthermore, worldwide trade is slowing significantly, and Canada is a price-taker and will have adjust to lower export values and likely lower terms of trade; both working against a reversal in the value of the loonie.

2. It is no longer apparent that Canada can expect portfolio investment to support the balance of payments as it has in the past .Indeed, the trend in portfolio investment has been declining over the last five years, all the while the current account deficit has widened. Canada will face competition for overseas capital from emerging markets offering similar natural resources.

3. To attract international capital, Canadian interest rates across the board would have to increase; however, any increase in domestic interest rates will have an adverse affect on the economy and will be counter productive in trying to eliminate our trade imbalances. ; it is unlikely the Bank of Canada would counsel such a policy move .

4. To the extent that it will be harder to attract new overseas investment, the loonie is unlikely to move far from its current range (USD=1.25-1.35). Any appreciation in the currency must come from improvements in the overall balance of payments, current and capital accounts.

Monday, October 5, 2015

Canada is no stranger in dealing with oil price collapses. The sharp fall in the price of crude in 2014 is not unprecedented. Over the past 30 years, there have been five major declines in the price of crude that have hit world markets ----- starting dates : June 1986, October, 1990, October 1997, May 2002 and June 2008. The plunge in prices has ranged from 25% to 60%. In all cases , Canada, as an oil-exporting country has had to bear the brunt of these precipitous and severe price declines, in terms of loss production, loss income and downward adjustments in its exchange rate and balance of trade.

Parallels with 1985-86

The current price collapse has significant parallels with that of 1985-86
(see Chart 1). In terms of the magnitude of the collapse, from peak to trough, prices fell by 59% in 1985-86 and by 56% in 2014-15. Both periods featured similar causes:

* A rapid and significant increase in supply ; 1986 featured the full expansion from new fields in the Gulf of Mexico and in the North Sea ; in 2014 the glut was caused by huge surge in production from unconventional sources such as oil shale in the U.S.

* A major shift in OPEC policy . In 1985, OPEC abandoned price targets and stepped up production by about 30% , the resulting low price remained in effect for nearly two decades; OPEC took a similar position in November 2014 by increasing supply and dropping prices to stem further losses in its market share; no longer will OPEC abide by price targets.

* Worldwide a fall off in demand; in the early 1980s, the recession reduced demand and this contributed to lower oil prices. Today, oil demand has been slowing steadily since 2012, especially in the larger emerging markets.

* A steady rise in the US dollar ; a rising US$ raises the local currency cost of oil ;the effect is to weaken the demand for oil.

Oil price drops of such magnitudes result in real income shifts from oil exporters to oil importers, Oil exporters have to then contend with fiscal imbalances, a decline in oil production and new investment, weak growth and foreign exchange adjustments We now turn a review of how Canada coped with these adjustments in the mid-1980s and what lessons can we learn regarding the adjustments needed today.

The Effects of Falling Oil Prices.

In oil-exporting countries, lower oil prices trigger currency adjustments, a re-pricing of credit and sovereign debt risk, and fiscal stimulus measures. Sudden price drops increase uncertainty in oil sector investment and in other goods-producing sectors. In sum, throughout the economy, capital investment is reduced or delayed and overall growth is diminished. Thus, both monetary and fiscal policy are called upon to support growth .

Monetary Policy

In response to the drop in oil prices in 1985, the U.S. Federal Reserve began a series of interest rate cuts to ward off the effects of slower economic growth and disinflation. Globally, economic growth slowed, especially in Japan and Europe. Canada followed the US lead in slashing its discount rate (see Chart 2 ) The US rate action was more aggressive than Canada's , in large part because Canada needed to have higher interest rates in order to attract capital inflows .Canada has traditionally been a capital importing country, and with its major export sector under duress, capital imports needed to be encouraged.

In both countries, there was sufficient room to reduce interest rates, given that short term rates were at 10% or more prior to the collapse of oil prices. This was an important buffer that allowed an orderly adjustment to the changed circumstances regarding growth, investment and the balance of payments, respectively.

Alas, as we will discuss later, no such buffer is present in today's world.Fiscal Policy

Canada and the US were running government deficits in response to the sharp recession of 1980-82. As Chart 3 reveals, deficit financing continued in response to the oil price shock of 1985-86. Canadian government deficit was 6.9% of GNP in 1985 and remained at 5% for the next three years. Interestingly, the governments of the day were working with quite difference in philosophy. The Liberal Government expanded its domestic programs ,while the Reagan Administration advocate smaller government; in both countries, the effects of the oil shock were tackled in the same way, namely through government deficits.

Impact on Growth

Chart 4 compares the growth per capita in the US and Canada during this period. Both countries were coming out of the 1980-82 recession with strong growth ; the US recorded real growth of 6.9% and Canada , 4.8% , in 1984. The oil price shock hit both countries, although Canada was hit harder in 1985 when growth dropped to just 1.4%.Without the accompanying monetary and fiscal stimulus, the results would likely have been worse.

Impact on Inflation
The Canadian currency took a tumble when oil prices plunged in 1985-86. The loonie dropped in value from 85 cents US in 1980 to 71 cents US in 1986, when the oil prices reached their cyclical low. As result, Canada was not able to take advantage of the worldwide deflationary effects . The US, on the other hand, saw its inflation rate drop to a low of 1.1% in 1986.

Is this Time Different?This is the perennial question when making comparison with the past. In our case, there are two things that stand out in answering this question.

First, the speed with which Canada was forced to adjust to the plunge in the price of oil price today is much faster than was the case in the mid-1980s. In the 12 months from June 2014, the Canadian economy slowed dramatically, recording 6 straight months of contraction in GDP. Within the sectors the goods-producing sectors contracted by 2.9% annualized; oil and gas, by 4.9%; construction, by 3.1% and manufacturing ,by 1.7%. This was a swift reversal of fortunes. Not unexpectedly, the balance of trade moved from a healthy surplus to a huge deficit in the first 6 months of 2015. And, reflecting all this rapid change, the loonie fell 20% in the first half of this year. Canada went from one of the best performers in the G-8, to one of the worst in quick fashion.

The IMF believes that "if oil prices are sustained around $50-$70per barrel....investment in the oil and gas sector could swiftly drop by some 30 per cent, thus lowering overall business investment by some 10 percent.... the terms of trade deterioration would trickle through to lower incomes. Overall, lower oil prices could depress real GDP by 1 per cent in 2015 and an additional 0.4 per cent in 2016" ( IMF " The Great Plunge in Oil Prices, March 2015)

An OECD forecast released this week, anticipates that Canada's GDP will grow at 1.1% per cent in 2015, down considerably from its June forecast of 1.5% growth. Matters have deteriorated rather quickly.

Second, Canada does not haveadequate tools to counteract these negative effects. The Bank of Canada has already cut the bank rate twice since January ,2015 ; it now stands at 0.5%, leaving very little room to cut further. We are now " pushing on a string" with regard to monetary stimulus .

The only remaining weapon available to stimulate growth is adjustments in the international value of the loonie ( see http://soberlook.com/2015/09/canada-joins-currency-wars.html). Now that the currency has depreciated nearly 30% over the past 2 years, the Bank of Canada has argued that the economy will return to positive growth in the latter part of the year and into 2016. The jury is still on this forecast, especially in the context of currency adjustments taking place throughout Asia and Europe ,as countries jockey for a competitive advantage in a world where trade is slowing rapidly.

Turning to fiscal policy, a recent Conference Board of Canada forecast anticipates that the Federal government alone will lose $4.3 billion in revenues from the oil patch--royalties and income tax, calling into question the prospects of a balance budget for fiscal 2015. Alberta is expecting a decline in GDP of 5% which will impact heavily on provincial revenues.

The Conservative government has introduced a balanced budget for 2015-16 and promises to continue this policy if re-elected. The NDP also promise a balanced budget. Only the Liberals call for deficit financing , albeit their deficits would be relatively small in comparison to the size of the Canadian economy, and not nearly the size of those experienced in the mid- 1980s. Overall, deficit spending to stimulate growth is not a top priority in Canadian politics . And, with monetary policy exhausted and with fiscal policy operating with one hand tied behind its back, Canada continues to remain vulnerable to the plunge in oil prices. All these developments in Canada are taking place within an environment of a global growth slow down, declining inflation and currency devaluations as Asia and Europe cope with weakness at home. Thus, the outlook for a return to growth is far from promising.

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Saturday, October 3, 2015

Friday's US jobs report combined with the September FOMC decision has significantly altered market expectations for the timing of the first hike by the Federal Reserve. The Fed Funds futures implied probability of a 2015 liftoff has dropped below 30%.

Source: barchart

In fact the expected trajectory of the rate hike probability has shifted in a similar fashion it did after the September FOMC meeting.

We see this shift in sentiment reflected in the 2-year treasury rates move on Friday.

Market participants are becoming uneasy about the loss of momentum in US labor markets. This latest concern comes on the heels of a number of other headwinds (discussed here) that resulted in the FOMC's September inaction on rates and weaker growth projections.

The softness in the labor markets is not limited to the latest payrolls report, which missed economists' forecasts. This year for example has been marked by downward revisions in estimates, as the Labor Department consistently overestimated job creation.

Another indicator that analysts have been focused on is the civilian labor force participation - which started declining again after leveling off for about a year. The US now has the lowest rate of participation since 1977.

The loss of momentum in the labor markets seems to be broader than just the manufacturing and energy/resource sectors. To be sure, the jobs situation in the United States is significantly better than in a number of major developed economies, but the improvement pace seems to have stalled.

Source: Deutsche Bank

To make matters worse, the wage growth acceleration many economists (including the Fed) have been promising never materialized (at least not yet). US wages continue increasing at around 2% per year and the concerns around wage pressures seem to have been overblown.

Given this latest shift in sentiment, we would like to conduct a quick survey on the timing of liftoff in the US. It's a single question (below) and the results will be published here and in the Daily Shot.

After the FED's decision of 17th September leaving interest rates unchanged, a great confusion has spread throughout the markets. The varied opinions have oscillated from the “disappointed” who were expecting, if not a rate increase, at least clear commitments towards a steady normalization path and the “crypto-hawks”, that have been arguing that the FED was only temporarily retreating only to accelerate the hike cycle in the following months. To be sure, Yellen and her spokespersons have not helped the markets to form a solid idea, by alternating contrasting declarations over just a week or more. Whatever the case, a view is crystallizing in the markets: the coming rate increases will be significantly smaller. This also holds true in the long term.

By looking retrospectively at the data, we have to admit that the “hold” decision was not unexpected at all by the markets (Figure 1).

Figure 1.

In fact, the implied probabilities calculated from the Futures' Prices on FED Funds tell us that the odds of a rate hike had been stable around 30% since mid-August: the markets were expecting a dovish decision and the FED was aware of it. It is interesting to analyze the main drivers of the operators' expectations, in the period July-September 2015 characterized by a frantic high volatility and a huge slip of the values on the equity side, connected with the Greek crisis (July 2015) and then with the Yuan's devaluation (August 2015).

Paradoxically, the expectations of a FED move on rates were largely unaffected from these two large regional crises at least in a direct way. The stark fact is that the markets have reacted punctually only to direct FED declarations. The perspective is perfectly logical: the FED is in charge to evaluate the broad macro-economic context while the markets follow closely the central bank guidance. In July, (see again Figure 1) one can appreciate a sensible increase of the odds of a rate hike in correspondence with the publications of the FOMC minutes the 8th of July, where the FED was shaping a definite track for the normalization of rates within the end of the year. The probabilities went up for the entire month of July, despite worsening of the Greek drama, the threats on China's slowing economy and the endless doubts about the real health of the US economy.

The second turning point that reversed in a decisive way the markets' expectations is the 18th of August; it’s worth noticing that during this day the FED released a discussed report in which it casts serious doubts on the effectiveness of the Quantitative Easing in boosting US GDP and inflation. Notably the 12th of August the People Bank of China had decided to abandon the Yuan's peg to the Dollar, igniting therefore a massive turmoil on world equity and FX markets, but the probabilities were remaining fairly constant until the FED report was published.

Again, the markets have waited for the “true interpretation” - via official documents - of the developments in the macroeconomic environment to adjust their expectations about the future evolution of interest rates. Other events affect short-term dynamics and boost expectations volatility but do not change the general trend “imposed” by FED guidance.

At the end of September, it seems that the games are done even for the FOMC October meeting (Figure 2). In this case, it’s not surprising that the main shift of expectations is given by the “hold” decision of the 17th September.

Figure 2.

The general consensus, reinforced by Yellen's declaration of the 25th of September that “a US rate rise is still likely this year”, is that the hike cycle should begin with the FOMC December meeting.

Nevertheless (Figure 3), the odds of a rates rising in December are generally decreasing. Indeed since 17th September it appears a bit more plausible that we will have the continuation of a loose monetary stance. Yellen’s statement has impacted on the numbers only to a limited extent, even if it has influenced the estimates for a few days - until the market participants have realized that no new official decisions were on the table.

Figure 3.

What’s happening on the long-term expectations? Intriguingly, irrespective of the official statements and the media gossip, they are cratering at all the time horizons analyzed (Figure 4).

Figure 4.

In less than two months, we can observe a reduction of 23% of the probability of a rate rise within the horizon of March 2016 and over 15% within the July horizon. Moreover, one can see the first significant change of expectations during the month of August and a second shock with the decision of the 17th of September. A focus on the future date of the July 2016 FOMC meeting (27th of July, 2016) confirms indeed that the August shift in long-term expectations is connected with the publication the 18th of August of the FED report on the effects of US Quantitative Easing.

Figure 5.

Figure 5 shows that markets estimate a more likely scenario to be a restrained interest rate increase, in the order of 25 basis points. The probability of a growth of the FED target rate of more than 50 basis points even on a longer time span is losing momentum rapidly. This forecast would be coherent with the framework of a slowing world economy, persistently low commodity prices and global deflation perspectives. The FED should indeed weight the risk of being caught in a zero interest rate environment trap by the time the next recession hits the US economy.